Psychological Possibilities

I've been reading the book by Kathy Lien and Boris Schlossberg called High Probability Trading Setups for the Currency Market. There is a section (on pages 15-16) explaining that what is mathematically optimal is psychologically impossible i.e. it is psycholigically impossible for a trader to be consistently succesful with a system that promises a high reward-to-risk (such as 2:1 or 3:1) from an optimised backtest.

The thing is you can follow some of the threads in the Trading Systems section to see that there are traders who have consistent success with higher risk to reward ratios. Is it possible that many of these systems are short-lived because the reward-to-risk is too high?

I think it's a difficult one because there are several variables, such as level of ability and experience, timeframe and frequency of trades, account and investment size, trading style (i.e. mechanical/program based versus discretionary) etc.

When we go about planning our money management and trading strategies, the reward-to-risk is obviously a crucial factor. Maybe we need to be more honest with ourselves and plan with a lower reward-to-risk ratio... It seems a difficult one because I imagine that for most people we can only learn what is bearable through experience. But then again, maybe it can be more simple than this...

I'm just like kick off a discussion about this. Hopefully some of the more experienced heads will be willing to share some pearls of wisdom...

Predicting next 1-10 minutes is a lot easier than predicting what will happen over days or even hours. Short time frames for taking profit mean smaller amount of reward, but a much greater level of predictability and consistency. Try to grab 5 pips before you lose 20. Yes, you will have to win 4 times to make up for 1 loss, but if you can learn to be very patient and limit amount of trades per day, you can definitely come out ahead.

Its important to be very patient and not try to get back into the positive if you do have a day where you lose a trade. Just figure its going to take a couple days to make it up. Don't go crazy and take a dumb trade and lose again. If you spot 2 really good trades for 5 pips each early in your seesion, turn off your trading platform and tell yourself you already won for the day and there's no need to trade anymore. You can still watch, but DON'T TRADE. On the other side, if you haven't entered a trade and a few hours go by and you start worrying you might not even take a trade that day, first, be proud of yourself that you are being selective, and second, quit worrying because you might get 2 trades in 20 minutes at any time of the session.

If you just don't see anything you liked very much all session, then close up shop and maybe you'll see a good one tomorrow.

Kathy and Boris know what they are saying and they're right, what is mathematically optimal is psychologically impossible.

Mathematically optimal means that, depending on your system and the Kelly formula, you can risk maybe 15% of your account per trade. Because you'll have inevitably some losses in a row it means you can lose half of your account very fast. Now, if you have 100K or more as your capital and you're losing 50K than the drawdown is not easy to digest even mathematically you'll recover your loss in the future.

So, better for your financial health is to risk 3% or less because protecting the capital has priority over taking optimal profits.

Now comes the nice part, the traders who claim high returns taking big risks. I have no proof that they are doing what they are saying and, as the laws of the numbers are against them, I suppose that they will not survive for long in the market.

There may be reasons other than psychological. What evidence is there that merely taking high RR value trades guarantees success? It wouldn't be difficult to write an EA to do so, thereby removing psychology as an issue.

A highly optimized backtest does not necessarily guarantee future profit.

But an EA that trades with a high RR value is bound to have some lengthy sequences of losses. Then it requires the trader to make a decision as to whether they should continue, so the psychological issue is always there.

I think the point of their argument is that it's very difficult psychologically to see a large profit on a trade turn into a loss (or breakeven), even when a backtest suggests that it's the optimal strategy. They also state that most professional traders scale out their positions which reduces their reward-to-risk to 1.5 or even lower.

I think there's more to this argument and the authors have probably generalised too much based on their experience. I do believe that a trader who is using an algorithm (or EA) which is optimised with the highest degree of confidence could enjoy greater success with a higher reward-to-risk ratio.

I'm slightly confused by the inconsistent use of RR terminology used in this thread. In some places it is stated as 'risk to reward' and in others it's stated as 'reward to risk'.

Mathematically these two are opposites. A high risk to reward ratio = a low reward to risk ratio and vice versa. There are reasons for preferring either depending on the strategy you're using and your sensitivity to loss.

As for the original point, I agree that using a mechanical system removes the psychological aspect completely. Success then depends on finding a profitable automated system.

The EA will (hopefully) remove the need to babysit trades, and hence whatever emotion is associated in doing so. But I agree, if an account experiences drawdown, some kind of psychological response is inevitable. There's an excellent post here by Topherhk88. His final 2-3 paragraphs address these issues.

For me personally, the psychological issue is not about RR, but whether or not I have a genuine, enduring edge. I won't venture beyond demo and microlots until I'm confident that I have. As a largely 'discretionary' trader, I can't easily resort to backtesting to help prove my methodology, which IMO places me at a significant disadvantage.

Interesting. Clearly these two know what trading is all about and what winning traders do. They'll tell you all about it in their new book.

...By the way, on an unrelated topic, anyone know whatever happened to that guy Chuck Hays who they featured in their book "Millionaire Traders"? He was running an obvious ponzi scheme but I wonder what became of him.


CFTC Charges Minnesota Resident Charles “Chuck” E. Hays and His Company, Crossfire Trading, LLC, with Running a $5.5 Million Ponzi Scheme

Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) filed an enforcement action today against Charles “Chuck” E. Hays and Crossfire Trading, LLC (Crossfire), both of Rosemount, Minnesota, charging them with fraud and misappropriation in connection with a commodity pool Ponzi scheme.


Hays, according to the complaint, convinced at least one person to invest in Crossfire by representing verbally and in fabricated account statements — issued on Crossfire’s letterhead — that Crossfire earned consistent profits trading commodity futures with no losing months. However, as charged in the complaint, Crossfire has never had an active commodity futures trading account. Additionally, in an attempt to alleviate at least two investors’ suspicions as to what Hays was actually doing with their money, Hays provided an account statement for the Crossfire pool fabricated to appear as if it were issued by a legitimate brokerage company by using that brokerage’s letterhead. This false account statement indicated that Crossfire maintained a trading account at the brokerage with over $37 million. As alleged, that account is nonexistent.

Furthermore, the complaint charges Hays with misappropriating investor funds to purchase a $4 million yacht, and for other purposes.